UC Santa Cruz

High Frequency Trade Direction Prediction

by

Augustine Stav

Abstract

High frequency trading involves large volumes and rapid price changes. The Volume Synchronized Probability of Informed Trading (VPIN) metric characterizes order flow toxicity. This toxicity is the unbalance of order flow between informed traders who possess knowledge of future price directions and market makers who do not have this information. VPIN requires trades to be classified as buys or sells and works with volume as a proxy for information arrival. As an alternative, trade volatility is determined from the trade direction. Subsequent trades are either at the same price, reversive, or trending. The virtual price takes continuous values between the bid-ask spread and exhibits Brownian motion. The realized price is the virtual price rounded to the nearest tick. Changes in the actual price occur when the realized price crosses the spread. The volatility parameter of the Brownian probability density function is determined so that the model has the greatest correlation to the observed trade directions. According to the Chicago Board Options Exchange Market Volatility Index, VIX, August 5th – 7th and August 20th – 22th, 2014 were periods of relatively high and low volatility for the S&P 500 respectively. The volatilities obtained for the high and low periods are (4.80 ± 2.02) dollars2/trade and (4.21 ± 0.71) dollars2/trade respectively.